America’s Perfect Storm, War, Tariffs, and Fiscal Reckoning Converge
As the Iran Conflict Escalates, the US Economy Faces an Extreme Test of Its Resilience
When President Donald J. Trump ordered strikes on Iran and risked a wider conflagration in West Asia, he was already gambling with an economy pushing against its limits. The decision to escalate military action dials up the economic hazards facing the United States from ‘very high’ to ‘extreme.’ This new stress compounds a series of other pressures already bearing down on the world’s largest economy, which is now even more unlikely to emerge unscathed.
The near-term danger is a setback in financial markets that gets out of hand. In many ways, some such reversal was already overdue, given the apparent overvaluation of US equities, the weight placed by tariffs on the economy’s back, the still-deteriorating fiscal outlook, and stubborn inflation. Add the risks of spiking energy prices, trade interruption, and global political turbulence, and the picture becomes genuinely alarming.
This is not a prediction of imminent collapse. The US economy has shown remarkable resilience through multiple crises. But resilience is not immunity. Every economy has its breaking point, and the convergence of multiple shocks—war, tariff uncertainty, fiscal deterioration, and inflation—tests that point as never before.
The Inflation Challenge
Inflation is a cause for concern even before factoring in the energy shock from the Iran conflict. The core producer price index, which excludes food and energy, increased by 0.8 per cent in January—markedly higher than expected. Its main components feed into the Federal Reserve’s preferred metric, core PCE inflation, which was running at 3 per cent in the year to December, still much higher than the Fed’s 2 per cent target.
On Monday, the Institute for Supply Management supplied more troubling evidence: it said the price of manufacturing inputs is rising at the fastest rate since 2022. This is not a story of inflation conquered; it is a story of inflation persisting despite aggressive monetary policy.
Into this already concerning picture arrives the energy shock. Oil prices rose as the strikes on Iran began, and analysts are now contemplating oil at over $100 a barrel, up from $65 before the offensive. This is not a trivial increase. A $35 jump in the price of oil ripples through every sector of the economy, raising costs for transportation, manufacturing, agriculture, and ultimately consumers.
As always, there is a reassuring best-case scenario. If all goes well, a quick campaign followed by a power shift in Tehran might lift the threat of future conflict and improve confidence in the global energy infrastructure, potentially bringing oil prices lower than they were before. But if the conflict continues and widens, if energy facilities come under sustained attack, if the Strait of Hormuz remains shut, then $100 a barrel might be decidedly optimistic.
Echoes of the 1970s
A lasting spike in oil prices would mean a return to the nightmare of the 1970s: stagflation. Higher inflation combined with slower growth creates a combination that the Federal Reserve is powerless to defeat. The traditional tools of monetary policy—raising interest rates to cool demand—work against inflation but further suppress growth. Cutting rates to stimulate growth fuels inflation. There is no good option.
Granted, the United States is now a net exporter of oil, so the domestic growth penalty would be less this time than in previous oil shocks. The country’s energy position has transformed dramatically over the past decade and a half. But the shock would still be global, the net effect on the US would still be stagflationary, and it would compound existing inflationary pressures rather than creating them from scratch.
The Fed, which has been walking a tightrope between containing inflation and avoiding recession, would find itself in an impossible position. Its credibility, carefully built over decades, would be tested as never before.
The Fiscal Backdrop
Look at America’s fiscal policy backdrop, and the picture becomes even more concerning. Whether the US still has a fiscal policy is very much in question. Even before the Supreme Court overturned so-called reciprocal tariffs, the outlook for public borrowing was testing limits.
Budget deficits at 6 per cent of GDP, even with the economy at full employment and relatively quiescent interest rates, mean that public debt will continue to grow faster than the economy. This is what ‘unsustainable’ means in fiscal terms. It is not a prediction of imminent default but a statement about trajectory. A country cannot indefinitely run deficits that outpace growth without eventually facing consequences.
The tariff setback from the Supreme Court will deprive the US government of around $150 billion a year of expected revenue. It might also have to refund tariffs already collected. To make good the shortfall, Trump has announced a new global tariff of 10 per cent, rising to 15 per cent under Section 122 of the 1974 Trade Act. He also promised ‘investigations’ that could lead to new taxes under other authorities—actions that threaten to upend trade deals with numerous partners.
In short, the court’s ruling guarantees two things: less revenue than previously expected, combined with even greater uncertainty about the future tariff regime. Businesses that need to make investment decisions, that need to plan supply chains, that need to forecast costs—they now face a level of unpredictability that is itself a tax on economic activity.
The Legal Quagmire
Section 122 tariffs can only be imposed for 150 days without Congress’s approval. They are probably illegal because their rationale—the need to address “fundamental international payments problems” including “large and serious balance-of-payments deficits”—arguably doesn’t apply. The United States has a big current-account deficit, financed by an equally big capital-account surplus, but no balance-of-payments gap in the traditional sense.
Other tools are legally questionable as well, because they mostly rely on some kind of urgent need to block trade. The administration is stretching the law to its breaking point, and courts are pushing back.
Congress seems remarkably unconcerned about this presidential abuse of its trade laws. Having gifted these supposedly limited delegations of power to the White House over decades, it now just watches as one bogus emergency follows another. The constitutional balance that was supposed to reserve trade policy to the legislature has been quietly abandoned, and Congress appears content with its irrelevance.
But litigation has stepped up. The legal setback underlines the fragility of the broader tariff strategy. As long as import taxes can’t be relied on—as long as every tariff is subject to legal challenge and potential reversal—businesses cannot plan around them. And until Congress is forced to take budget control seriously, the revenue shortfall will worsen, and high fiscal uncertainty will ripple across the world.
The Fiscal Space Problem
Washington will have little or no fiscal space for a real crisis. This is perhaps the most underappreciated vulnerability. In previous downturns, the federal government could borrow cheaply and spend aggressively to stabilise the economy. The 2008 financial crisis and the 2020 pandemic both saw massive fiscal responses that prevented even worse outcomes.
But those responses were possible because the United States entered those crises with fiscal room to manoeuvre. Debt levels, while significant, were manageable. Interest rates were low. There was confidence that the government could borrow without triggering a crisis of confidence.
That room has now been substantially consumed. Debt levels are higher. The fiscal trajectory is steeper. And the political system shows no signs of addressing the underlying imbalances. In a genuine emergency—a deep recession, a financial crisis, a prolonged war—the government would need to borrow massively. Whether markets would absorb that debt on reasonable terms is an open question.
Uncertainty Off the Scale
Uncertainty off the scale might be the hammer blow. At a certain point, confidence tested repeatedly could mean everything suddenly gives way. How much disruption can the US economy, for all its strengths, absorb?
Businesses make investment decisions based on expectations about the future. When those expectations become clouded—when the path of tariffs is unknown, when the trajectory of fiscal policy is uncertain, when the prospect of war creates unknowable risks—investment freezes. Hiring slows. Expansion plans are postponed. The economy gradually loses momentum.
Consumers, too, respond to uncertainty. When the future looks unpredictable, saving increases and spending decreases. Big-ticket purchases are deferred. Debt is paid down rather than expanded. The animal spirits that drive a dynamic economy become subdued.
Financial markets, which had been remarkably resilient through multiple shocks, begin to price in higher risk premiums. Equity valuations, already stretched by historical standards, become vulnerable to any bad news. Bond markets demand higher yields to compensate for uncertainty. The dollar, long a safe haven, could come under pressure if the United States is seen as the source rather than the solution of global instability.
The Compound Effect
None of these risks, taken individually, is necessarily fatal. The US economy has weathered oil shocks before. It has navigated fiscal challenges. It has absorbed trade disruptions. It has managed inflation.
But the compound effect of multiple shocks arriving simultaneously is different. The interactions matter. Higher oil prices feed inflation, which constrains monetary policy, which worsens the fiscal outlook, which increases uncertainty, which depresses investment, which slows growth, which reduces revenue, which worsens the fiscal outlook further.
This is not a linear process but a circular one. Each problem amplifies the others. And the cumulative effect can be much larger than the sum of the parts.
Conclusion: Doubling Down
US trade and budget policies were already gambling with financial disaster. The fiscal trajectory was unsustainable. The tariff strategy was legally fragile and economically disruptive. Inflation was proving stubbornly resistant to monetary policy.
With the Iran strikes, the White House has doubled down again. It has added a major geopolitical risk to an already precarious mix. It has increased the probability of an energy shock that would compound inflationary pressures. It has introduced a new source of uncertainty into a system already groaning under uncertainty.
The US economy is strong. It has shown remarkable resilience through multiple crises. But resilience is not infinite. Every economy has its breaking point. And the convergence of war, tariff chaos, fiscal deterioration, and stubborn inflation brings that breaking point closer.
Whether the economy reaches it depends on factors that no one can control—the course of the conflict, the response of other nations, the reactions of markets, the behaviour of consumers and businesses. What is clear is that the margin for error has shrunk dramatically. The White House is gambling with an economy that has no spare capacity for further shocks.
Q&A: Unpacking the Economic Risks of the Iran Conflict
Q1: What are the main economic risks facing the US economy from the Iran conflict?
A: The primary risks include a spike in energy prices that could push oil above $100 per barrel, compounding existing inflationary pressures; financial market disruption as investors reassess geopolitical risks; trade interruption if the conflict widens and affects shipping through critical chokepoints like the Strait of Hormuz; and stagflation—the combination of higher inflation and slower growth—which the Federal Reserve has limited tools to address. These risks compound existing challenges including fiscal deterioration, tariff uncertainty, and stubborn core inflation.
Q2: How serious is the inflation situation before factoring in the Iran conflict?
A: Inflation remains troubling even without the energy shock. Core producer prices increased 0.8 per cent in January, markedly higher than expected. Core PCE inflation, the Fed’s preferred metric, was running at 3 per cent in December—well above the 2 per cent target. The Institute for Supply Management reported manufacturing input prices rising at the fastest rate since 2022. Adding an energy shock to this already concerning picture would make the Fed’s job of containing inflation while avoiding recession extremely difficult.
Q3: What is the fiscal situation, and how does the Supreme Court’s tariff ruling affect it?
A: The US is running budget deficits of 6 per cent of GDP despite full employment, meaning public debt continues to grow faster than the economy—the definition of unsustainable. The Supreme Court’s overturning of reciprocal tariffs will deprive the government of about $150 billion in expected annual revenue and may require refunding tariffs already collected. To compensate, the administration has announced new tariffs under legally questionable authorities, creating enormous uncertainty for businesses and worsening the revenue shortfall.
Q4: What does “no fiscal space” mean, and why does it matter?
A: “No fiscal space” means the government has limited capacity to borrow and spend in response to a crisis. In previous downturns (2008, 2020), the US could borrow cheaply and deploy massive stimulus because debt levels were lower and confidence remained high. With debt now substantially higher and the fiscal trajectory steeper, markets might not absorb additional borrowing on reasonable terms. This leaves policymakers with fewer options to stabilise the economy if the Iran conflict triggers a severe downturn.
Q5: Could the US economy actually break under these pressures?
A: The US economy is remarkably resilient, but resilience is not infinite. The concern is not that any single factor will cause collapse, but that multiple shocks—war, energy spikes, inflation, fiscal deterioration, tariff uncertainty—will interact and amplify each other. Higher oil prices feed inflation, constraining monetary policy and worsening fiscal outlooks, increasing uncertainty, depressing investment, slowing growth, reducing revenue, and further worsening fiscal trajectories. This circular process can produce cumulative effects much larger than the sum of individual shocks. While collapse is unlikely, the margin for error has shrunk dramatically.
